Yellen says downturns require swift action

The danger that serious downturns do lasting damage to an economy means policymakers need to act “aggressively” when responding to a major setback, the Federal Reserve chair said as she called for more research into a host of economic conundrums dogging central bankers around the world.

Janet Yellen said poor economic performances since the financial crisis suggest that a plunge in demand can have a persistent effect on the supply capacity of an economy.

Citing research showing that US potential output is 7 per cent below what might have been expected based on its pre-crisis trajectory, she told a conference that it was crucial for monetary and fiscal policymakers to act quickly when a recession hits.

“If strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand,” she added in the conference hosted by the Federal Reserve Bank of Boston.

Ms Yellen’s argument came as the Fed pursues an ultra-gradual approach to removing monetary policy support in the US amid a sluggish recovery. She did not address immediate rate-setting issues in her speech, instead raising a series of questions that she said economists needed to dig more deeply into as they try to improve their understanding of the world after the crisis.

Ms Yellen said that it was sensible to ask whether running a “high-pressure economy” with robust demand might reverse damage to an economy’s supply side, for example, by boosting corporate sales and therefore encouraging investment, or by pulling individuals off the sidelines and into the labour force.

Among the other questions Ms Yellen raised was how to account for the fact that differences between the circumstances of individuals or companies in an economy can influence overall outcomes, challenging economists’ models incorporating a single “representative” agent.

For example, in an assessment of the impact of a housing downturn on spending, some households might curb spending more severely than others if they are driven into negative equity. Employment at small firms might be hit harder than at large ones at a time when banks are trimming lending, as they did during the crisis.

Ms Yellen also said the economics world needed a stronger understanding of how the financial sector interacts with the broad economy — a lesson economists have been vowing to learn since the banking meltdown of 2007-09 but which continues to haunt them. The Fed chair asked, for example, whether the persistently high saving rate since the crisis was a result of tougher lending standards by banks and other lenders.

Central bankers are also struggling to get their heads around the factors that drive inflation. The links between the health of the labour market and price growth are particularly relevant to the Fed right now.

Policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand

Similarly, the Fed is grappling with how inflation expectations are shaped, amid weak readings in some surveys and market measures. And the Fed is also attempting to better account for the ways in which changes in its monetary policy ricochet around the world, ultimately feeding back into conditions in the US.

“Extreme economic events have often challenged existing views of how the economy works and exposed shortcomings in the collective knowledge of economists,” Ms Yellen said.

“Pursuing answers to these questions is vital to the work of Federal Reserve and other economic policymakers, and the Fed is likewise engaged in ongoing research to seek answers.”